Robots really are coming for your job. At least if you’re an investment advisor.
Over the past decade, a new type of financial advisor has emerged to compete with traditional investment advisory firms. These robo-advisors began as startups backed by venture capital, designed to disrupt the stodgy financial industry.
They succeeded so well that many investment banks have now introduced their own robo-advisors.
But before deciding whether to open an account, make sure you understand robo-advisor pros and cons, and exactly how they work.
What Are Robo-Advisors?
Sometimes called virtual advisors, robo-advisors are automated services that manage your investments for you.
They offer convenient, transparent portfolio management for accounts of all sizes. And they do so at a fraction of the cost of traditional human investment advisors.
When you open an account with a robo-advisor, you fill out a questionnaire to determine your long-term financial goals, risk tolerance, and basic demographics like your age.
Their algorithm then proposes an investment strategy for you, based on best practices for people like you. You can approve it and proceed, or edit your answers to tweak the proposed asset allocation.
As a simple example, say a virtual advisor proposes 40% U.S. stocks, 40% international stocks, 15% bonds, and 5% real estate. Once you approve that asset allocation, then every time you transfer money into the account, it invests your contributions automatically to maintain those ratios.
Most robo-advisors don’t invest in individual stocks. Instead, they invest in passive index funds that mimic major stock market indexes like the S&P 500. That gives you broad exposure to the market with extremely low fund fees (expense ratios).
In short, robo-advisors manage your investments just like a human investment advisor would. Except without the high fees or minimum investment balances.
Examples of Robo-Advisors
You’ve probably heard of many of the robo-advisors available on the market. Although not an exhaustive list, here are a few of the better-known examples of virtual advisors:
- Personal Capital
- SoFi Invest
- Schwab Intelligent Portfolios
- Axos Invest
For more detail, see our list of the best robo-advisors on the market right now.
Basic Robo-Advisor Features
All robo-advisors share certain core traits.
As you start browsing robo-advisors, keep the following features in mind.
Most robo-advisors keep their fees far lower than human advisory services. Some, such as SoFi Invest and Schwab Intelligent Portfolios, don’t charge an asset management fee at all.
Beyond asset management fees — which are charged as a percentage of the total amount you have invested — robo-advisors also help you save money on fund fees.
Every mutual fund and nearly every exchange-traded fund (ETF) charges a fee called an expense ratio. These can be as low as 0.05% per year for passively managed ETFs — the kind robo-advisors invest in — or as high as 2% or more for actively managed mutual funds.
Robo-advisors keep both types of fees low for you.
Low (or No) Minimum Investment
Robo-advisors have truly democratized the world of asset management and investment advising.
Most human investment advisors require a minimum investment ranging between $50,000 and $250,000 — or more — because they earn their fee as a percentage of assets under management.
By contrast, most robo-advisors require far less to open an account, if anything at all. A few charge a minimum monthly fee, while others don’t bother with that either.
It takes around five minutes to open an account with a typical robo-advisor.
You start with the basics required for all brokerage accounts including name, address, and Social Security number, and usually, you connect your bank account to be able to transfer funds.
Then you fill out their brief questionnaire to set your risk tolerance, investment goals, preferences, and when you want to retire.
The robo-advisor proposes an asset allocation based on your criteria, you approve it or continue tweaking your profile, then you can deposit funds and let the algorithm do the rest.
Better robo-advisors let you set up automated recurring transfers. By automating your savings, you don’t need to rely on willpower to save and invest each month.
It also removes emotions from your investing, which yields far better results. Instead, regular automatic investments allow dollar-cost averaging — a tried and true approach to investing.
I have my robo-advisor set up to transfer a certain amount of money every single week. I never have to lift a finger and never have to think about it — it just happens in the background.
Your asset allocation drifts over time as parts of your portfolio perform better than others.
What started as 40% domestic stocks, 40% international stocks, 15% bonds, and 5% real estate might drift to 35% domestic stocks, 50% international stocks, 5% bonds, and 10% real estate after a few months.
So robo-advisors automatically rebalance your portfolio for you. They sell some of those shares that have performed well and buy more of the shares that haven’t performed as well.
While that might sound counterintuitive, it helps you sell high and buy low, and prevents your portfolio from becoming overweight in one type of asset.
Features of the Best Robo-Advisors
Not all robo-advisors are created equal. Some are free while others charge; some offer dozens of bells and whistles while others keep it simple.
On the higher end of the spectrum, keep an eye out for these premium features.
More Account Options
Most robo-advisors offer a bare minimum of taxable brokerage accounts and IRA account options.
But some take it even further, servicing 529 plans, trusts, 401(k) accounts, and health savings accounts (HSAs). If you need more advanced types of accounts, confirm whether a robo-advisor offers it before opening an account.
Some of the higher-end robo-advisors offer tax-loss harvesting to reduce your tax bill. For example, Betterment suggests its proprietary tax-loss harvesting program can increase total returns by 0.77% annually.
Tax-loss harvesting involves selling “losing” investments to offset capital gains on your winners. It reduces your capital gains tax bill, which helps boost your effective returns.
Socially Conscious Investing
Not all investors have strong feelings about socially conscious investing, but those who do consider it a nonnegotiable.
Some robo-advisors offer the option to only invest in investments considered socially responsible. Like tax-loss harvesting, this is a more premium feature, rarely found among entry-level robo-advisors.
Human Hybrid Advisors
The more personalized financial advice and investment customization you want, the more you’re going to pay.
Think of investment advising as a spectrum. On one end lie the simplest, and usually cheapest, robo-advisors. On the other end of the spectrum lies 100% bespoke human investment advising, where you get as much personal attention and customization as you want.
As you move along that spectrum, you start seeing more of the bells and whistles. And the greatest premium feature of all is a living, breathing human investment expert to work with you one-on-one.
These human hybrid advising models have exploded in popularity over the past few years. In this hybrid approach, you start by going through the same questionnaire, and the algorithm provides you with the same proposed investment portfolio.
But from there, you can hop on a call with a live investment advisor to discuss your portfolio further. Together, you fine-tune your asset allocation to meet your unique needs and goals.
Once set, your account works like a robo-advisor. You automate transfers, and it automatically invests and rebalances according to your asset allocation. When you have investing questions or when you want to adjust your portfolio allocation, you can connect with a human advisor.
Who Should Use Robo-Advisors?
The average middle-class American doesn’t need a human investment advisor, hybrid or traditional. They can simply take advantage of free or low-cost robo-advisors to help them begin building wealth.
However, as you climb the ladder from middle class to wealthy, your needs change. Your portfolio starts getting more complex, your taxes go up dramatically, you have to start worrying about lawsuits and asset protection.
Above a certain net worth — if you have to pin a number on it, let’s say $500,000 — consider upgrading to a human hybrid advisor for more personalized investing advice.
If you have $1,000 to start investing, open an account with a free robo-advisor. If you have $1 million, start looking at either a human hybrid or a traditional human investment advisor.
The Future of Robo-Advisors
The advent of free robo-advisors raises a question: How do these companies actually make money?
Think of free robo-advisors as a loss leader for investment advisory companies. It’s a free service to onboard lower- and middle-income clients to help them start investing.
As those clients start seeing traction and building wealth, they develop as potentially profitable. Advisory firms can then market other services to them, such as human hybrid advising, financial planning services, insurance, mortgages and loans, and for wealthier clients, full human advising.
That’s how I envision the industry evolving. In the 20th century, only the wealthy used these advisory companies. In this century, I expect most Americans to use them, and the companies themselves to make most of their money selling progressively higher tiers of services to middle- and upper-class clients.
With the rise of robo-advisors, working- and middle-class Americans can now get expert help getting started with investing. No account minimums, no high fees, just fast and easy investment management and advisor services.
Which also means no excuses for not investing your savings. Open an investment account, even if you only have a spare $20 as an opening account balance, and start letting your money work for you for a change.